Fiscal Deficit and Inflation

There is a lot of debate on this in Indian media. And I have been busy trying to find some empirical work on the same.

Here is a paper (oldish) by IMF economists, Luis Catao and Marco Terrones:

Macroeconomic theory postulates that fiscal deficits cause inflation. Yet empirical research has had limited success in uncovering this relationship. This paper reexamines the issue in light of broader data and a new modeling approach that incorporates two key features of the theory. Unlike previous studies, we model inflation as nonlinearly related to fiscal deficits through the inflation tax base and estimate this relationship as intrinsically dynamic, using panel techniques that explicitly distinguish between short- and long-run effects of fiscal deficits. Results spanning 107 countries over 1960-2001 show a strong positive association between deficits and inflation among high-inflation and developing country groups, but not among low-inflation advanced economies.

I tried reading this paper but was too technical for me. Hence, can’t comment much. Anyways, those more technically endowed can read it and explain it if possible.

Empirical studies have had little success in finding a statistically significant relationship between fiscal deficits and inflation in broad cross-country panels. This paper provides new econometric estimates for a panel of 23 emerging market countries during 1970-2000. Unlike previous studies, we allow for a rich dynamic specification and focus on the long-run relationship between the two variables controlling for differences in the inflation tax base. We find that a 1 percentage point reduction in the ratio of fiscal deficit to GDP typically lowers long-run inflation by 1½ to 6 percentage points, depending on the size of the inflation tax base.

This again is pretty technical.

In all, there seems to be some effect. More so for emerging econs. Happy reading.